Inflation, money, things & people

"Inflations is always and everywhere a monetary phenomenon".

Increasing money supply
Let's play monopoly. Only this time with a twist. We have one board, one set of properties, hotels, cards etc. However we have two sets of monopoly money. Here's how we play. For the first hour we play one set of properties, one set of money. At the end of the first hour add the second set of money, shared amongst all the players. What do we notice? We would notice a step change (increase) in the general level of prices as players bought and sold properties. Such a step change would be immediately obvious and would (rightly) be attributed to the extra cash added to the game.

Now let's be sneaky. Again we start play with one board, one set of properties, hotels, cards etc, and one set of money. However in this game, every time a player passes GO we secretively give him extra cash to the tune of 2% of his current position (cash + properties). After 35 rounds (about 4 hours), there is twice as much money circulating as before (1.02^32 = 1.99), except the players are not aware of this fact.

So what do the player notice? Fabulous returns on property!! "I bought Mayfair for $400, and sold it 2 hours later for $600. I then bought all the utilities for $800 and had them at the end worth $1600. How clever am I!!" What else would we observe? Well the fines and rents seemed increasingly trivial as the game went on (hint, they're not indexed to inflation).

Welcome to life. In reality we have more than just property as an asset class. With inflation we see the prices of bonds, property, commodities, equities all rise, though not necessarily in synch. The central banks can add money, but they can't say where it will go. So what happened? Bonds rose, equities rose (and peaked 2000), real estate rose (and peaked ~2006), commodities rose (and possibly peaked 2008).

Money supply versus physical goods

So let's play monopoly again. This time after the first hour let's double the board (properties, hotels, players), but keep just one set of monopoly money. What would we notice? Sharp property price falls as the same amount of money was shared by more player bidding on more properties. Oh my goodness, we'd have massive deflation, a monopoly depression!!

Okay, let's try a different game. Play with one board and one set of money, but after 1 hour we remove half of the money by making players hand it over. If need be they have to sell their assets to do so. Again we have falling prices and a monopoly depression.

Money supply growth, population growth and productivity

It's all relative in a growing economy. If we double the monopoly board and double the money, we won't see different prices, just a bigger game. In the real world increasing the 'board' is achieved through population growth (birth rate, immigration, death rate); while increasing physical stuff is achieved through productivity growth (more with less, technology, science, innovation etc). Globalisation also plays a part as production and services are procured from overseas workers. Increasing the amount of money is achieved by increasing central bank money (M0), and commercial bank money (M1-M3).

Price stability - balancing growth in money, people, stuff
So here's my theory. Assuming stable population, innovation and productivity, inflation (general price levels) are always and everywhere a monetary phenomenon. The more correct general theory would be that inflation is function of money, population and goods growth.

The boom years 1980-2000
In a previous post I discussed asset price appreciation and reducing inflation (the great moderation). Following this thought further I believe we can see macroeconomic factors in light of money supply, population and goods growth.

Global Money Supply
Total money supply growth has clearly been at high levels since the 1980s. In recent times we have seen extensive money growth in many nations as they try to competitively devalue their currencies. See the chart at left based on data 2007 money supply from Wikipedia. This is clearly inflationary, but what has happened to population growth?

Global Population Growth
Well nothing abnormal in an absolute sense, but in a productive capacity we have added 3 billion Chinese, Indians, Brazilians, Thai's, Malaysians, Vietnamese and so on. That is clearly deflationary.

Global Productive Growth
Three things have impacted productive capacity. First, industrial/digital inventions such as computers, internet, biotec, agri-tec and so on. Second, business management techniques have improved (lean six sigma, just in time manufacture, ERM, CRM and so), and are more standardised through global companies. Thirdly, more countries are now moving into manufacturing so more 'stuff' is being made.

From the mid 1980's I belive that productive growth + population growth exceeded money supply in the financial economy. That's why inflation moderated with all the benefits associated with price stability.

In the current situation (2008), money supply is contracting due to the credit crisis (banks have lost too much money) whilst population and productive growth is stable. This calls for general price deflation according to my model. Of course the (asset) price reductions won't be even. We have already had trillion dollar real estate and equity losses. So it is not unsurprising to see some rises in bond and commodity prices. Look for more of the same over the medium term.

Global Money Supply

In this post we look at Global Money Supply (M0 to M3). For a primer look at 'What is money' and 'What is money supply, inflation?'. But first a massive hat tip to Mike Hewitt at DollarDaze.org for his 2008 Global Money Supply update.

First, a table showing global money supply by the top 25 nations. Note that China, Russia, India and Norway did not publish M3, so an average multiple on M1 was used to estimate that data.

There are two very interesting facts in this table. The first is that top 6 countries account for 80% of M3, and the top 9 for 90%. Second, note that the average M3:M1 multiple is 19.4. This means that there is nearly 20 times more money in circulation that the money 'officially' printed by the respective central banks. Welcome to fractional reserve banking. This is consistent with an average 5% reserve requirement. See 'What is reserve banking?' for more information.

The next table looks at money growth for the same 25 nations ranked according to M0 year on year (yoy) growth. The rows shaded green show the top 6 (top 80%) nations according to M3 from above.

What is interesting in this table are the different growth rates for different countries. Since M0 is central bank control money, this is the best indication of what nations are doing. As of July 2008, we see the US and Japan having very slow money expansion, where as developing nations and petro-nations have high money growth. The reason for this high money growth is that these nations seek to maintain currency parity with the US dollar. So as the US dollar falls (becomes worth less for domestic economic weakness), these nations must print and sell their currency to maintain parity.

This excessive money printing is responsible for inflation in these nations. Remember to quote 'inflation is always and everywhere a monetary phenomenon' and you'll sound like an economist!

One last point, M3 can be a misleading money growth indicator as it captures large sums of money in money market accounts and liquid assets. During turning points in the economy, risk-adverse investors may sell assets such as property and equities and place this money in M3 type accounts. Of course this doesn't change the amount of money, just it's composition.

More to follow!

What is Fractional Reserve Banking?

Here we look at the history, function, operation and some criticisms of fractional reserve banking. This is important as most every nation has a FRB system in place.

History

In the middle ages goldsmiths would take deposits of gold/silver coins and issue 'goldsmiths notes' to depositers. Over time these notes became a trusted medium of exchange. Soon goldsmiths realised not everyone would want their gold at the same time and began to issue more 'goldsmith notes' in loans than they had in actual gold. Thus were born the first banks which paid interest to creditors (depositers of gold/silver) and received interest from a greater pool of debtors (people the bank loaned money to).

Function

The US Federal Reserve summarises FRB:
Banks borrow funds from their depositors (those with savings) and in turn lend those funds to the banks’ borrowers (those in need of funds). Banks make money by charging borrowers more for a loan (a higher percentage interest rate) than is paid to depositors for use of their money... For the economy and the banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Referred to as the fractional reserve system, it permits the banking system to create "money".

Money Creation

Modern banks start with money from the nations central bank (M0). From here the amount of commercial bank money created through loans depends on the reserve requirements of the bank. From the NY Fed:
If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000).

Control of Money Supply (and inflation?)

We see that the money supply is either central bank money (M0) or commercial bank money (M1-M3). We also know that inflation is 'always and everywhere a monetary phenomenon'. So how can central banks control money supply?

• Central bank money. Central banks can directly adjust their supply of money as they control the physical (notes/coin) and electronic creation of money.
• Commercial bank money. Central banks control this through regulation by changing the reserve requirements on banks. For example, a 10% reserve requirement enables $100 to become $1000. A 20% reserve requirement reduces that figure to $500. Capital ratio requirements also limit the types of loans banks can make (more low risk loans, fewer high risk loans).
  

Criticisms of Fractional Reserve Banking

There are two general criticisms of FRB. The first is that changes in money supply rely on the commercial bank lending process. When contracting money supply, this can be achieve easily as bank foreclose or withdraw credit in response to higher central bank imposed interest rates or reserve requirements. However, when seeking to expand money supply, the bank must have a willing borrower to borrow the new funds into existence. When the economy enters a down turn, borrows may not be willing to do this. Thus lowering interest rates and/or reserve requirements in a slow economy can be like 'pushing on a string'.

The second criticism is that increasing money supply artificially through money creation effectively lowers the cost of money (interest rates) through a simple supply demand mechanism (more money than goods). Alternatively, reducing money supply can create money shortages (for loans etc) which pushes up interest rates. Low interest rates can lead to over investment in unproductive assets (such as US housing from 2002-2006). High interest rates can lead to under investment in assets needed for current and future productive capacity.

Business cycle recessions are seen by Austrian School economics (more later) as necessary to liquidate unprofitable investments made due to artificially low interest rates. Once liquidated, capital is freed up for new investment in productive assets to take place.

What is Money Supply, Inflation?

In ‘What is Money Supply?’ we look at different types of money, where it comes from and what it means for the economy.

Money supply

Money supply (sometimes called money stock) is the total amount of money held by the non-bank public. When classifying money we generally separate categories as follows (note different countries do this differently):

• M0. All physical currency (notes & coin), as well as central bank accounts that can be exchanged for physical currency (see what is money)
• M1. M0 plus money in checking or current
• M2. M1 plus most savings accounts, money market accounts, and small term deposits (certificates of deposit).
• M3. M2 plus all other term deposits (CDs), institutional money-market funds, repurchase agreements and other large liquid assets.

The practice of fractional-reserve banking leads to large variations in money supply.

Fractional-reserve banking

Most nations use fractional-reserve banking. When banks give out loans in fractional-reserve banking a new type of non-M0 money is created (the M1-M3 components). Large differences in the different types of money exist based on bank margin requirements. The above image shows money supply for the US (www.dollardaze.org). FRB is covered in more details in a dedicated post.

Money and inflation

The money supply equation (MV=PQ) provides a useful framework for considering the link between money supply and inflation. Here:

• M is the total supply (M0 to M3) of a nation.
  
• V is the velocity of money measured as the number of times per year each dollar is spent.
  
• P is the average price of all goods and services sold during the year.
  
• Q is the quantity of all goods and services sold during the year.
  

We simply here that if money (M) is expanded through excessive fiat money printing, then the average prices of goods and services (P) will increase. Provided money velocity and the quantity of goods and services remains constant. The increases in prices (P) will be called inflationary and a nations reserve bank will look to target that figure to the 1-3% range depending on the country.

So what is inflation?

A simple definition is that it is 'rising prices'. But that is just the symptom. What is the cause of inflation? Inflation is believed to be caused by excess money supply (fiat money printing). This was famously acknowledged by Milton Friedman with 'inflation is always and everywhere a monetary phenomenon'.

It is also important to understand that inflation measures such as the consumer price index (CPI) are an overall economic indicator. Like all averages, CPI is made up of rising and falling components. Lets look at different components:

• Rising: Food, fuel, healthcare
• Steady: Housing costs*
  
• Falling: Consumer electronics, automobiles, clothing

How you perceive inflation depends on where you live and the type of purchases you make. Let's consider three different countries:

• Indonesia: majority of purchases are food/fuel related. Indonesian's are experiencing very high inflation:
• USA: mix of food/fuel/housing expenses. Food/fuel are rising, however costs of housing are falling (July 2008). If you are buying a house then you stand to benefit from a large price decline (deflation) in housing saving you potentially tens or hundreds of thousands. If you already have a house, you are seeing only rising prices for food/fuel which is inflationary.
• Australia: mix of food/fuel/housing expenses. Food/fuel are rising, but with its booming economy, rising interest rates (not falling like in the US) is making housing and rents more expensive! Inflation in Australia is over 4% and the populace knows it.

In 'What is fractional reserve banking' and 'How to benefit from inflation' we look in more detail at these issues.

Curious readers can find out more about money supply

What is Money?

Seems a simple question but the definitions of money and credit and their importance are aggressively debated by the best economic minds. Read on to see why.

Money is anything that is generally accepted as payment for goods and services and repayment of debts. Conventional opinion has it that money includes currency (circulating currency with legal tender status), and various forms of financial accounts such as savings, deposit, cheque and term deposits.

Money is an important part of an economy. With out money, two parties to a transaction must not only agree on a ‘price’, but also the medium of exchange. For example, I might well believe the car wash was worth two goats, but I may only have two sheep to pay with (which might be unacceptable to the car washer). Such friction results in higher economic costs.

Money is considered to be 1) a store of value, 2) a unit of account, and 3) a medium of exchange. Noted economists argue for distinguishing among different types of money as follows:

1. Commodity money is that actually contains its purported economic value. That is, a gold coin stamped ‘$50’ is actually worth $50 in real gold value. Historical examples of commodity money include gold/silver coins, copper, shells, precious stones and so on.
2. Representative money consists of token coins, notes or electronic certificates that can be swapped for a quantity of real commodity such as gold. It represents a real and direct relationship to a known quantity. For example, the US 1913 $50 Gold Certificate was “Fifty Dollars in Gold Coin Payable To The Bearer On Demand.”
3. Credit money is any future claim, such as an I.O.U., against a physical or legal person that can be used to purchase goods and services. Other examples include treasury, savings or corporate bonds, or bank money market account not immediately redeemable.
4. Fiat money is any money whose value is determined by a government act, and declared to be officially recognised payment for all debts, both private and public.
   

Regarding fiat money, consider the US 1914 $1 Bank Note after the introduction of the US Federal Reserve. At the time it was issued, a ‘note’ was well understood to be a promise of payment. And what is this Note redeemable in? Here's what it says: "Secured By United States Certificates Of Indebtedness Or One-Year Gold Notes, Deposited With The Treasurer Of The United States Of America". The Note was directly redeemable in Treasury debt, but it was not directly redeemable in Gold.

Now fast forward to 1963 and the US $1 note simply states: “This Note Is Legal Tender For All Debts Public And Private”.

Fiat money has advantages over commodity money in that it can be ‘replaced’ if the note is lost or damaged, unlike commodity money which is lost for good. Fiat money has several disadvantages though:

• The stability of fiat money is related to the stability of the government system declaring the money into existence. Any failure of the government which issues the legal tender will undermine the value of that money.
• If the declaring government issues more fiat money than available goods and services, then higher prices will likely result (defined as inflationary in some circles). 1920’s Germany or current-day examples of nations experiencing hyper-inflation as a result of excess (fiat) money printing.

Most all modern nations adopt fiat money management by a Federal Reserve banking system.

Wikipedia provides a more detailed summary on the 'History of Money', reproduced here for reader ease:

According to some fables, inventors of money were Demodike (or Hermodike) of Kymi (the wife of Midas), Lykos (son of Pandion II and ancestor of the Lycians) and Erichthonius, the Lydians or the Naxians. However, the use of proto-money may date back to at least 100,000 years ago, and the use of precious metals as money dates back at least 6000 years. The use of gold as money has been traced back to the fourth millennium B.C. when the Egyptians used gold bars of a set weight as a medium of exchange, as the Sumerians had done somewhat earlier with silver bars. Coins or at least minted tokens of a fixed value first appear in the 7th century BC in Greece. The first banknotes was used in China in the 7th century, and the first in Europe was issued by Stockholms Banco in 1661.”

Curious readers can find out more about 'A History of US Paper Money' here with thanks to www.the-privateer.com.

• ‘A History of U.S. Paper Money': http://www.the-privateer.com/paper.html
• Money: http://en.wikipedia.org/wiki/Money

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